Answers

What is the Private Finance Initiative (PFI)?

PFI is a procurement method where the private sector finances, builds and operates infrastructure and provides long term facilities management through long term concession agreements. These agreements transfer substantial risks to the private sector in return for payments over the concession life which is usually at least 25 years. Payment is only made if services are delivered according to the requirements of the concession agreement.

Why PFI instead of traditional procurement?

The Private Finance Initiative (PFI) was established by the Conservative Government by in 1992. It was aimed at improving the poor public sector track record in infrastructure procurement and its associated long term management. In 1997 the new Labour government decided to continue with PFI and provided the resources within the Treasury and government departments to set priorities, improve the basis of project selection and develop both the process and a standard contract.

In 2003, the National Audit Office estimated that 73% of procurement under traditional methods of procurement was delivered over budget and 70% was late.

PFI was a challenge to both the public and the private sectors to change the way infrastructure was procured and to overcome long established adversarial relationships and low levels of trust that existed between the two sectors. Today relationships between the public and private sector generally work very well and in this regard PFI has achieved one of its purposes. It also has succeeded in significantly improving the way public services are being delivered even within the public sector.

How does PFI work?

A PFI project involves a long-term, usually 25 year, contractual arrangement between public and private sector parties through a concession agreement.

The private sector agrees to finance and build an infrastructure project such as a hospital, school, road or prison and to provide long term lifecycle investment and routine maintenance services sometimes together with ‘soft services’ such as catering and cleaning. In return, it receives a semi annual payment stream over the life of the concession from the public sector client provided it delivers the services to the specification set out in the concession agreement. So there is no payment for poor delivery or performance.

How big is PFI?

PFI is one of the largest, if not the largest, infrastructure sector in the UK. Over the past 15 years some 600 projects with a capital value of over £60billion have been signed. This includes almost 100 hospital schemes, over 100 education projects covering more than 800 schools, 43 transport projects and over 300 other operational projects in sectors such as defence, leisure, culture, housing and waste.

This has been the biggest investment in UK infrastructure since the Victorian times and has only been made possible using PFI type procurement. It would not have been possible for government departments to procure on this scale using traditional procurement. Their human resource requirements alone would have been difficult to achieve.

On the ground, this has meant that hundreds of thousands of pupils are now being educated in new and modernised schools which offer up to date learning, technology, sport and arts and crafts facilities. This represents a step-wise increase in investment in the UKs future work force.

In 2007 50% of the NHS estate dated pre-1948 and some of these structures were only meant to be temporary. Today, this figure stands at 20% and the 25 year PFI contract should ensure that these countrywide new healthcare facilities are both run efficiently and well maintained and serviced for the foreseeable future.

The prison service has been reformed as a result of PFI prisons and the private sector provision of custodial services.

Who are the principal participants in this industry?

The private sector participants include the leading and largest UK and international:

building contractors and service providers

insurance companies

banks and bond investors

equity investors including pension funds and insurance companies

professional advisors

The public sector participants include government departments (eg Health, Transport, Home Office, and Defence) and local authorities (schools, street lighting, social housing, waste, local roads maintenance).

Risk

The concession agreement only transfers those risks to the private sector which the latter is best placed to take. This means construction cost overruns and delay costs are borne by the contractors, finance costs are borne by the finance providers and service delivery by the service contractors. All under the umbrella of each PFI project. The private sector has shown by experience that it is able to manage these risks very well. There are few, if any, examples of construction risk being returned to the public sector. During the financial crises no signed projects have been bailed out and, for the most, part payment deductions for poor service industry-wide have been low.

The umbrella of the project company creates an additional discipline which is one of the underlying drivers of efficiency and performance. This is because the finance providers only receive their returns if their contractors deliver the project and services. So instead of the public sector driving the project it is the finance providers, led by the equity investors who are at most risk.

Is PFI only used in the UK?

PFI type procurement and know-how has been exported to many countries although it is not referred to by the same term. Programmes go by the name PPP or P3 etc but they all use the same underlying concept.

Programmes are in development in USA, Eastern Europe, Turkey, and South East Asia.

Are PFI Contracts too expensive?

These projects are procured in open competition in accordance with rules drawn up by the Government and the European Union. The competition drives out excess costs and the resulting price should be considered the market price which takes into consideration all the project risks.

The majority of contracts in the UK were negotiated before 2008 at a time when debt and equity was readily available and relatively cheap. In current markets, these projects today would be more expensive to finance.

How much more expensive is a PFI project than a traditionally procured project?

The overall cost of financing a PFI project has been typically about 2.25% pa more than that of a traditionally procured project. This is because the government cost of finance is less than the private sector.

The private sector price is the market price for taking on a project with its inherent risks. A lower government cost amounts to a subsidy as these risks would be underpriced. This is because the project risks are the same whoever provides the finance. Nevertheless, it would be cheaper.

The expectation is that the efficiencies that will be delivered by the private sector through risk transfer will more than compensate for the additional cost. For example, building the project to budget and on-time together with the more efficient service delivery and maintenance during the life of the project.

Are PFI projects providing over generous returns for investors?

Large refinancing profits were made by some investors on some of the early projects. In 2002, voluntary arrangements were agreed to share up to 50% of these profits with the public sector. The profits were made possible because the cost and term of financing became cheaper as confidence grew (i) from nothing in the new services based infrastructure sector and (ii) in doing business with the public sector (previously very difficult and often claims based). So it became possible to refinance many of the earlier projects (ie replace the project finance) at a profit. These profits did not arise because the costs of building the project or delivering the services turned out to be cheaper than envisaged in winning the original project but because the new finance providers were prepared to accept lower returns since their perception of the risks had reduced. Winning a PFI project concession is a hard fought competition where the cheapest price usually wins.

As PFI developed in the last decade, these refinancing opportunities receded as the finance became cheaper, discounting many of the earlier risks and concerns.

The other way investors have made (and lost) money in PFI is through buying and selling equity investments in the project companies between each other. This does not impact on the underlying project and is no different from any other equity market where buyers and sellers place a value on their investment assets and trade them.

Because of the political dimension, where the government of the day is the public sector customer, the prospects for existing investment (value) and new infrastructure investment (new money) will be sensitive not only to government’s approach to the sector but also to the perception by investors as to whether the risk profile of doing business with government is likely to change.

How important is design?

In the early years of PFI competing bids were evaluated primarily on price. This led to some projects which, while functional, providing poor civic amenities. The industry pushed hard on the public sector for design to be an important part of the bid evaluation so that communities could have new long lasting facilities they could be proud of and which could also be the driver for local improvement and regeneration.

This is even more important in deprived areas where a new local school is a facilitator for social change and offers children a chance for social as well as educational development.

What is happening now in PFI?

Since 2008, the flow of new PFI projects has slowed to a trickle. This is because the UK PFI infrastructure programme has slowed considerably in the face of the weakening of the UK economy and the disruption in world financial markets.

The government has indicated that going forward there will be more focus on investing in new economic infrastructure (energy, broadband and transport) rather than social infrastructure (hospitals, schools and prisons).

As part of its deficit cutting programme, particularly in relation to reducing public sector spending, work is under way to see where savings can be made on PFI projects. The Treasury has recently issued a Guidance Note to indicate areas where savings could be made. Private sector and public sector parties are currently working together to try to achieve these.

The Treasury has also recently announced a new Select Committee inquiry into the future prospects for PFI. This will provide the opportunity for a wide range of interest groups to provide evidence and for proposals to be made on the future direction of PFI and the role of private sector investment in the UK infrastructure.